The beauty of dividends for investors

Falling interest rates mean investors now have to work extra hard to achieve a decent return on their money. But don’t forget that it is the after-tax return that counts – this is why an understanding of the way franked dividends work is essential.

Before the Hawke-Keating government introduced imputation in July 1987, shareholders suffered double taxation on their dividends. First the companies paid tax on any profits they made, then the shareholders were taxed again when they received these tax-paid profits as dividends. As the top marginal tax rates then were more than 60 per cent it meant the total tax take could be as high as 78 per cent.

Since then, dividends from companies that have borne the Australian company tax rate carry imputation credits. The word “impute” means to “give credit for” and this is exactly what the imputation system does. It allows shareholders to receive credit for the tax paid by any company in which they hold shares, and pay tax only on the difference between that and their own tax rate.

If you owned 10,000 shares in a company and it paid a franked dividend of 7¢ a share, your dividend would be $700 and would carry with it imputation credits of $300 as a result of the tax already paid by the company.

You are entitled to use those credits to pay your own tax – in other words they are as good as cash, but only if you spend the money at the Tax Office. As the credits represent value, you have to pay tax on them. Yes, even though you received only $700, you have to declare $1000 ($700 + $300) as taxable income. That’s the bad part – now comes the good bit. You can use those credits to offset your tax bill and possibly even reduce it.

How it works in practice

Jack earns $70,000 a year on which tax is $14,300 a year. He buys a portfolio of shares that produces franked dividends of $7000 a year as well as providing $3000 of imputation credits. When he does his tax return he will have to add $10,000 to his taxable income, that’s the sum of the dividend plus the franking credit, which will take his taxable income to $80,000. His tax bill will rise by $3200 to $17,500 because of the extra $10,000 of income, but he now has the use of those $3000 worth of imputation credits to pay it. They almost wipe out the tax on the dividend – the tax is just $200.

If Jack had earned that extra $7000 from bank interest he would have had to pay $2275 tax on the interest, and would have no opportunity for capital gain. This is what makes shares paying franked dividends so popular with experienced investors, and why shares are such a great investment for retirees who can handle their volatility.

It’s even better for investors in super funds because they can claim a refund of unused franking credits. If the fund received $7000 in franked dividends the tax on those dividends would be just $1500 but you would be entitled to $3000 in franking credits. For you, the dividends wouldn’t be just tax free – they would carry a bonus of $1500 as well.

Readers often send me emails that say “All your examples are fine but you never take tax into account”. Well, think about an investor who earns $150,000 a year, and who has a $200,000 share portfolio – a typical long-term return may be 9 per cent a year made up of 5 per cent growth and 4 per cent franked income of $8000 plus $3400 of franking credits. There is no tax on the $10,000 growth because capital gains tax is not triggered until the asset is sold and the tax on the $8000 dividend income grossed up to $11,400 would be $4218 less $3400 in franking credits. That’s a total yearly tax of just $818 on a total return of $18,000. Sure beats bank interest.